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Global Economic Outlook
Canada Outlook Update: External Risks Undermine Domestic Demand
By Tetiana Sears
- Growth in 2011 will suffer as external headwinds from the weaker U.S. outlook weigh on domestic demand.
- Consumer spending and business investment will continue to be the main growth drivers, offsetting weaker net exports amid faltering external demand and softer commodity prices.
- In response, the Bank of Canada (BoC) will further delay policy normalization to counterbalance moderating domestic and U.S. growth and fiscal austerity measures.
Figure 1: Latest Data and RGE Forecasts
*Year-end policy rates
Macroeconomic Dynamics: External Headwinds Threatening Domestic Demand
After growing by 3.7% q/q on average in 2010-11, Canadian growth stalled in Q2 2011, posting a mild 0.4% contraction with net trade exerting a substantial drag on growth, while domestic demand advanced a healthy 3.0% annualized. Although RGE expects economic activity to pick up in H2, weaker U.S. and global growth and the lingering European sovereign debt crisis will adversely affect the pace of growth in Canada, reinforcing the softening of domestic demand. As a result, we now expect annual growth at 2.1% y/y in 2011, compared with our earlier estimate of 2.4% y/y.
This moderation will continue in 2012, reinforced by fiscal restraint, sluggish consumption and a weak external sector, with growth averaging 1.8% (down from our previous 2.2%), which is slightly below Canada’s long-term potential.
Early Q3 data suggest that the reversal of temporary factors that severely hit auto and resource sectors in Q2 could help improve trade performance and industrial output in the quarter. However, lackluster growth in the U.S. and falling commodity prices will keep the trade balance in the red going forward. The Canadian dollar, hovering close to parity with USD, continues to challenge the noncommodity exports and productivity growth remains disappointing.
As net exports fail to pick up the economic baton, personal consumption and business investment will continue to drive growth. However, growth in personal consumption will suffer from negative wealth effects (household net worth fell 0.3% q/q in Q2 and likely further in Q3), faltering consumer confidence, muted income growth and little space to take on additional debt. Easing commodity prices and low interest rates could provide some reprieve to debt-burdened households.
Business investment in machinery and equipment has been trending upward since early 2010, but most likely peaked in Q2 after reaching the 15-year high of 31% annualized. The weaker domestic and external demand dampens business sentiment, curtailing further expansion in capital spending. Moreover, falling business confidence also translates into slowed hiring, following strong growth in private-sector full-time employment in H1. In the near term, the unemployment rate will climb to the mid-7% range as more people enter the labor force.
Policy Implications: Further Delay in Policy Rate Normalization
As heightened external headwinds adversely affected the Canadian economy, the BoC assumed a dovish stance, suggesting that the central bank is in no hurry to resume monetary tightening. This neutral stance is also consistent with the Fed’s additional two-year commitment to maintain monetary stimulus with imminent QE3. Moreover, the recent easing of global energy prices has alleviated pressure on headline inflation. After peaking at 3.4% y/y in Q2, the headline measure is now on track to average 2.7% in 2011, slightly below our previous estimate of 2.8%. Meanwhile, the gradually closing output gap, reflecting material growth slowdown in Canada, will keep core inflation in check, which will converge with the headline measure at the 2% target only after 2012.
These dynamics prompt us to move our forecast for the resumption of monetary tightening even further out to early 2013 from late 2012. As significant monetary stimulus now will remain in place for a much longer period, this should provide sufficient support without reverting to interest cuts to help counteract fiscal austerity measures and weaker domestic and U.S. growth.
In recent statements, the Canadian government signaled its commitment to the fiscal consolidation plan envisioned in the June budget update, in which spending cuts are primarily backloaded to 2012 and 2013. However, should Canadian growth stall for a second consecutive quarter, the government is likely to delay the spending cuts and may introduce additional stimulus aiming at sustaining fragile growth. These changes, if implemented, along with the weaker growth that prompts them, would delay the planned closure of the fiscal gap by 2015.
- U.S. recovery strengthens, supporting demand for Canadian goods.
- Stimulative credit conditions spur another consumer spending binge.
- Additional stimulus measures help create more jobs.
- Residential investment maintains upward trend.
- A more severe U.S. and global recession pulls Canadian growth into a downward spiral via trade and financing channels.
- Disorderly resolution of the European debt crisis leads to tightening of credit and financial conditions.
- Households continue to increase debt levels reinforcing longer-term vulnerability.
Figure 2: Domestic Demand is Driving Growth (q/q, annualized)
Source: Statistics Canada
Figure 3: Pickup in Manufacturing is Encouraging but Could Be Short-Lived (SA, %, y/y)
Source: Statistics Canada
Figure 4: Financial Conditions Remain Very Stimulative (%)
Source: Bank of Canada